Glass Steagall Act of 1933, Its Purpose and Repeal

This 1933 Law Would Have Prevented the Financial Crisis

The Glass-Steagall Act is a 1933 law that separated investment banking from retail banking. Investment banks organized the initial sales of stocks, called an initial public offering. They facilitated mergers and acquisitions. Many of them operated their own hedge funds. Retail banks took deposits, managed checking accounts, and made loans.

Glass-Steagall prohibited investment banks from having a controlling interest in retail banks. They had to find another source of funds separate from depositors' accounts.

It prohibited bank officials from borrowing excessively from their own bank.

The act introduced Regulation Q. It prevented banks from paying interest on checking accounts. It also allowed the Fed to set ceilings on interest paid on other kinds of deposits.

The official name for Glass-Steagall was the Banking Act of 1933 (48 Stat. 162). The law was named after its sponsors, Senator Carter Glass, D-Va. and Representative Henry B. Steagall, D-Ala.

When It Passed

Glass-Steagall was passed by the House of Representatives on May 23, 1933. It was passed by the Senate on May 25, 1933. It was signed into law by President Roosevelt on June 16, 1933 as part of the New Deal. It became a permanent measure in 1945.

After the law passed, banks had one year to decide whether they would become investment or commercial banks.

Purpose

Glass-Steagall sought to permanently end bank runs and the dangerous bank practices that created them. Congress passed Glass-Steagall to reform a system that allowed the failure of 4,000 banks during the Great Depression. It had debated the bill during 1932. It redirected bank funds from fueling stock speculation to building industrial capacity.

Since 1922, the stock market had gone up by almost 20 percent a year. Banks invested in the stocks. When the market crashed in 1929, depositors rushed to withdraw their funds. By March 8, they had withdrawn $1.78 billion in just four weeks. Others demanded gold in return for the money. The United States was still on the gold standard. But the demand was so high that the Federal Reserve was running low on its gold deposits.

A bank run will put even sound banks out of business. Banks keep just one-tenth of their deposits on hand and lend out the rest. Most of the time, they only need 10 percent to fill depositors' demand. In a bank run, they must quickly find the cash.

On March 6, 1933, President Roosevelt declared a four-day bank holiday. On March 9, Congress passed the Emergency Banking Act. It allowed banks to reopen on March 13. Banks would no longer exchange dollars for gold. Instead, the Federal Reserve printed dollars to meet depositors' demand. The currency was based on the banks' paper assets. By March 15, most banks had reopened to find the bank run was over.

Effect

Glass-Steagall restored confidence in the U.S. banking system. It increased trust by only allowing banks to use depositors' funds in safe investments. Its FDIC insurance program prevented further bank runs. Depositors knew the government protected them from a failing bank.

During the Reagan administration, the banking industry complained the act restricted them too much. They said they couldn't compete with foreign financial firms that could offer higher returns. The U.S. banks could only invest in low-risk securities. They wanted to increase the return while lowering the overall risk for their customers by diversifying their business.

Citigroup had begun merger talks with Travelers Insurance in anticipation of Glass-Steagall. In 1998, it announced the successful merger under a new company called Citigroup. Its move was audacious, given that it was technically illegal. But banks had been taking advantage of loopholes in Glass-Steagall.

Repeal

On November 12, 1999, President Clinton signed the Financial Services Modernization Act that repealed Glass-Steagall. Congress had passed the so-called Gramm-Leach-Bliley Act along party lines, led by a Republican vote in the Senate.

The repeal of Glass-Steagall consolidated investment and retail banks through financial holding companies. The Federal Reserve supervised the new entities. For that reason, few banks took advantage of the Glass-Steagall repeal. Most Wall Street banks did not want the additional supervision and capital requirements.

Those that did became too big to fail. This required their bailout in 2008-2009 to avoid another depression.

Should Glass-Steagall Be Reinstated?

A reinstatement of Glass-Steagall would better protect depositors. At the same time, it would create organizational disruption in the banking industry. This might be a good thing, as these banks would no longer be too big to fail, but it should be managed effectively.

Congressional efforts to reinstate Glass-Steagall have not been successful. In 2011, H.R. 1489 was introduced to repeal the Gramm-Leach-Bliley Act and reinstate Glass-Steagall. If these efforts were successful, it would result in a massive reorganization of the banking industry. The largest banks include commercial banks with investment banking divisions, such as Citibank, and investment banks with commercial banking divisions, such as Goldman Sachs.

A part of the Act, known as Volcker Rule, puts restrictions on banks' ability to use depositors' funds for risky investments. It does not require them to change their organizational structure. If a bank becomes too big to fail and threatens the U.S. economy, Dodd-Frank requires that it be regulated more closely by the Federal Reserve.